Morgan Stanley thinks investors should diversify into these markets

Morgan Stanley senior portfolio manager Andrew Slimmon recommended Japan and European equities, highlighting banks and defense as beneficiaries of rising corporate earnings estimates. He said upward earnings revisions are the key difference in 2026 and could drive these markets higher as investors recognize the strength of the earnings outlook. Slimmon also remained optimistic on U.S. equities despite narrow breadth and a Fed rate increase, noting the market has been flat since May while earnings revisions continued to rise.

Analysis

The actionable signal is not geographic beta but a potential re-rating of markets where earnings revisions can close a persistent valuation discount. Japanese financials—MUFG, SMFG and TSE banks—have unusually high operating leverage to further normalization in domestic yields, while improved capital-return policies make upward EPS revisions more likely to translate into lower discount rates rather than merely higher book-value accumulation. The key 1-3 month test is whether revision breadth expands beyond exporters and financials; without that, broad EWJ exposure is less attractive than targeted banks.

European banks remain the cleaner near-term earnings-revision expression, but the risk is that markets are pricing a higher-for-longer net-interest-income runway than deposit beta and ECB easing will permit. Prefer franchises with fee income, excess capital and low commercial-real-estate risk; EUFN offers diversified exposure, while BNP.PA, ISP.MI and UBSG.SW are more defensible than highly rate-sensitive domestic lenders. A 50-100bp faster-than-expected easing path would likely compress 2027 EPS estimates and reverse the trade within months.

European defense has a longer 6-18 month order-book catalyst but is more vulnerable to valuation compression after strong performance. Procurement conversion, rather than announced budgets, is the critical variable: Rheinmetall, Leonardo and Saab benefit disproportionately when multiyear commitments turn into funded contracts, while capacity constraints support margins but can defer revenue recognition. The contrarian risk is that broad foreign-market enthusiasm becomes crowded before revision data confirms it; this is not, by itself, a catalyst for MS, whose direct sensitivity is primarily through cross-border capital-markets activity.

U.S. index-level resilience alongside improving revisions argues against a broad de-risking signal, but favors rotation into revision breadth rather than chasing the largest constituents. If U.S. revisions stall while Japan/Europe breadth continues to improve, relative flows could support EWJ and EUFN even amid flat global equity indices; a renewed dollar surge or global PMIs rolling over would falsify that relative thesis.

Key Decisions for Investors

• Initiate a 3-6 month pair: long MUFG and SMFG (equal weight) versus short EWJ, sized market-neutral. Target 10-15% relative return if Japanese yield normalization and buybacks sustain; stop if Japanese 10-year JGB yields retreat below the post-policy-normalization range or FY earnings guidance fails to rise at next results.
• Add selectively to EUFN on weakness rather than chase European defense beta; pair with a partial short of a rate-sensitive European equity basket if available. Underwrite a 3-6 month trade only if consensus 2026-27 bank EPS revisions remain positive; exit on a materially more dovish ECB path or evidence of accelerating deposit repricing.
• For a 6-18 month structural allocation, prefer a basket of RHM.DE, LDO.IM and SAAB-B.ST over ITA: European procurement localization and backlog conversion are the differentiated drivers. Cap position size because valuation risk is high; reduce if order intake/backlog conversion misses two reporting periods or a credible ceasefire changes procurement urgency.
• Do not position around MS from this commentary. Use MS as a watch item only: upgrade the capital-markets earnings thesis if announced EMEA/Japan equity issuance and M&A volumes accelerate for two consecutive quarters; otherwise the direct revenue impact is too diffuse for a standalone trade.